What are the global pressures holding back inflation?
Broadly speaking, inflation globally continues to run behind what many would expect in an environment of moderate growth, testing assumptions about the economic recovery. Both domestic and external factors are holding back inflation. We believe the stronger headwinds are coming from the manufacturing and export sectors most exposed to global deflationary trends, while more domestically-focused services sector inflation tends to be somewhat healthier. For instance, oil prices are a big drag on headline inflation, and this is more a reflection of global oversupply than declining demand. Domestically, low wage growth in many of the world’s largest economies is a major factor.
What about the emerging markets?
The slowdown across emerging markets (EM) means many of these economies are unlikely to generate much domestic inflation. But on top of that, the dramatic weakening in EM currencies means these economies are exerting disinflation through import substitution, keeping pressures down globally. One globally significant feature of China’s slowdown is that now the world’s second-largest economy is exporting more excess capacity. For instance, in the steel sector, developed world producers are under pressure from China’s oversupply. One example is in the UK, where a number of domestic producers have gone bankrupt. China’s gravitation up the value chain may also be exerting downward pressure on inflation, as we believe China now has the capacity to outbid developed world manufacturers on infrastructure projects.
Why are we so pessimistic on Eurozone inflation?
Inflation in the region is disappointingly low. There’s not much evidence that quantitative easing (meaning central bank asset purchases) is impacting the core inflation rate (which omits volatile food and energy categories). The economy still has a lot of underutilized capacity, with unemployment in double digits. Structural factors are also contributing to a very weak wage dynamic across Europe. One is labor mobility, with people moving from the peripheries to Germany and increasing immigration. Ongoing competitiveness adjustments are another factor, as Italy and France are working to reduce unit labor costs. And job creation is skewing away from higher skilled manufacturing positions to lower-paid services jobs.
We also see more general headwinds for consumption. Europe’s demographics are challenging—in an aging society households tend to be more inclined to save. Moreover, debt stocks are still high in parts of the euro area and we think doubts about fiscal sustainability may be an added constraint on consumer spending.
Could Japanese inflation finally be taking off?
Recent updates are encouraging. Japan’s headline inflation is weak, but the core rate excluding food and energy picked up to 0.9% in September. With unemployment around just 3.4%, Japan's labor market is very tight, and though wage growth has been slow to improve, we see clear evidence of capacity constraints. These reasons may be sufficient to delay further policy easing for now, but we think a move is likely in the next six months. Inflation isn’t picking up as quickly as the Bank of Japan’s forecasts suggested.
What positive inflation drivers are you seeing in the US?
The big difference in the US picture is core services, where inflation has been rising steadily this year. This leads us to believe that traditional inflation dynamics aren’t dead, that is, that the strengthening economy and declining unemployment are closing the output gap and price pressures are building. But the US, like everywhere else, faces secular disinflationary pressures. One is income redistribution, from households to corporations and from lower- to higher-income earners, which is a transfer of income to entities with a lower propensity to spend. Technological advances are also exerting disinflationary pressures, along with the shift in economic activity from manufacturing to services. Service sector workers tend to have less bargaining power, while manufacturing workers have tended to be higher paid.
Looking ahead, we may see a lower inflation regime if these pressures intensify. In our view, US headline inflation will likely trend back toward 2% over the next 18 months, but possibly not much beyond that.
